European Bank recapitalizations: An imminent credit crunch

29 October 2011

This post is archived. Opinions expressed herein may no longer represent my current views. Links, images and other media might not work as intended.

The latest summit did not produce a comprehensive solution as many expected (see The aftermath of the October 26 Euro Summit – No Solution). Apart from the consensus on certain policy areas and despite the vague figures and numbers that are not backed by any tangible plan; the decisions of the summit are full of gaps, with vital details remaining open to further negotiations. One of the few issues that is explained in some greater detail is the process of bank recapitalizations (see Annex 2 of this 14-page document that contains the official decisions of the latest summit). The positive aspect of this plan is that it finally accepts, with great delay, that European banks are quasi-bankrupt and are in desperate need for capital otherwise they will continue to destabilize the system. The negative is that the process of recapitalizations is designed in such a way that will produce adverse effects and recession in the short-to-medium term.

The reason that is true has to do with the multi-level process and with its voluntary manner. Banks will first be expected to raise capital from the market, if they fail to do so they will resort to national authorities and if those are unable to provide assistance, the EFSF will be called to carry the task. Banks are expected to meet their capital targets by June 30, 2012. In practice this suggests that bankers have a considerable time ahead to work out all necessary steps that will allow them to avoid losing control of their banks, since recapitalization implies partial or full nationalization/europeanization, depending on the amount of capital that each bank will need.

Instead of designing a plan like the one in the USA, the TARP (Troubled Assets Relief Programme), which was a nation-wide scheme that included compulsory recapitalizations; European elites came up with the self-defeating idea of allowing bankers the time to avoid nationalization, by asking from them to basically instigate a credit crunch, since if all banks are asked to raise capital from the market, they will have to draw it out of the real economy, in whatever way possible. In short the real economy will be deprived of much-needed liquidity in the midst of a recession. Without any central plan to stimulate growth only the private sector can push the European cart out of the mire of stagnant growth, yet without sufficient liquidity this is impossible. Without growth the crisis can only get worse.

The prudent choice would have been to copy the successful detoxifying exercises of TARP by transforming the EFSF into a mechanism that would be assigned the exclusive task of recapitalizing banks in a forceful way, effectively changing their boards of directors. This would allow for an immediate, coherent, Euro-wide programme that would bring Europe’s banks back to healthy standards, by cleansing them from all their toxic assets, while also giving the opportunity to policy-makers to devise a simultaneous restructuring of private and sovereign debts. This is however politically undesirable for a number of reasons, hence we end up in a complex plan that favors bankers instead of Europe and its people, by allowing them precious time to do what best serves their own interests.

Compulsory and immediate recapitalizations are key. A non-compulsory recapitalization plan is going to produce adverse effects as not only it fails to address the underlying insolvency of many banks, it also allows them to continue to act like black holes to the system, effectively absorbing all the liquidity that goes their way. Banks are basically asked – and expected – to retard growth even more, by further reducing the amount of liquidity they supply.

Moreover the idea of expecting from national authorities to recapitalize their banks can prove unpleasant, as many sovereigns will be forced to accept their inability to support their banks, which alone is not a good sign for the markets. Yet even if they are capable of doing so, the amount of capital they will have to pump in to their banks can be enough to trigger downgrades from credit agencies. This is especially true for France and Belgium. The point that needs to be made clear is that France cannot afford to lose its triple-A rating at this stage, as that would immediately lead the EFSF into jeopardy, thus effectively tearing apart the whole plan European elites have in their minds.

I already offered my first comments on the October Summit explaining how European elites failed to come up with any ‘comprehensive’ solution. All they did was to kick the can forward, however in their attempt to buy more time (what for?) and governed by despair they have come up with a series of proposals that effectively make the crisis worse. The plan to recapitalize banks is certainly one of them, as it will further deepen recession, effectively killing at birth the latest incomplete package European policy-makers produced.